Risks to Watch at JPMorgan Chase

JPMorgan Chase (NYSE: JPM) has built a reputation as the world's premier megabank. As other banks collapsed during the financial crisis, it held up. As other banks struggle to find their niche, it's thrived. It has managed risk better than peers, maintained a stronger balance sheet than peers, and established more trust with investors than nearly any other bank.

What could go wrong?

Banking is risky by nature. Many things can go wrong -- and frequently do. On top of the usual recession fears, here are three risks investors should watch at JPMorgan.

Mindblowing complexityBe honest with yourself. Do you understand the following statement, which I pulled from JPMorgan's annual report?

As of December 31, 2011, the notional amount of single-name CDS protection sold and purchased ... was $142.4 billion and $147.3 billion, respectively, on a gross basis, before consideration of counterparty master netting agreements or collateral arrangements ... Credit derivatives protection purchased and sold are reported based on the underlying reference entity and is measured at the notional amount of protection purchased or sold, net of the fair value of the recognized derivative receivable or payable. Credit derivatives protection purchased and sold in the Firm's market-making activities are presented on a net basis, as such activities often result in selling and purchasing protection related to the same underlying reference entity, and which reflects the manner in which the Firm manages these exposures.

Maybe you do. If so, great. And congratulations! But for the vast majority of JPMorgan shareholders, this might as well be written in hieroglyphics.

Trying to understand how a bank works and values its assets is often a lesson in indecipherable market-babble. Even those with advanced finance degrees -- heck, even the people running the banks -- can be left overwhelmed.

And, dangerously, those operations and asset values could potentially cause havoc down the road. The number one reason bank investors were demolished in 2008 was that they didn't understand the risks banks were taking or how they were generating profit. Very few people did. The complexity of big banks is so great that the biggest risk investors face is something totally unknown and unforeseen. You don't know what will happen tomorrow because you can hardly understand what's happening today.

Regulations, lawsuits, and other angry people wielding pitchforksConsumer banking used to be based on a simple concept: Checking accounts were free (or nearly free), but banks made money on debit-card interchange fees, overdraft fees, and ATM fees.

Then the Dodd-Frank banking regulation changed the game. Limits were placed on overdraft changes, debit-card interchange fees were capped, and various other clampdowns changed the dynamic between commercial banks and customers. Banks responded by and large by hiking fees on checking accounts. And many of those customers voted, as they say, with their feet. According to J.D. Power and Associates, the customer defection rate at large banks was around 10% last year, up a quarter from the year before.

The fee caps and customer defections aren't a significant blow to JPMorgan, which is widely diversified beyond consumer banking. But it's a good example of how a changing regulatory climate after the 2008 financial crisis can upend business segments. And no one knows the boundaries of that risk.

Then there are lawsuits. JPMorgan has spent $12.5 billion on litigation expenses in the past three years, mostly representing fallout from the housing bubble. The more recent LIBOR interest rate-rigging scandal poses another round of expensive lawsuits. Analysts at investment bank KBW recently estimated (and that's all it is) that the LIBOR scandal could result in an industrywide settlement of $35 billion, of which it estimated JPMorgan's share could be $4.8 billion. No one quite knows how it will play out, but we do know this: Big banks, including JPMorgan, made many poor decisions, they have lots of money, and people are getting more comfortable suing them. It's not a kind arrangement for shareholders.

Waning loan demandFor decades, banks could count on Americans' insatiable appetite for more debt. Business loans, credit cards, mortgages, auto loans -- there was no end in sight. Total private debt (business and household) grew an average of 9.3% a year from 1960 to 2007. For banks looking to rapidly grow their loan books, this was as good as it gets.

But we're in a different world today. The economy as a whole, driven by households, is in a "deleveraging," working diligently to rid itself of debt. Total private debt today is below where it was four years ago -- the first time in modern history the industry has experienced a sustained decline.

This poses a new problem for banks like JPMorgan. For the first time since perhaps the Great Depression, weak demand for loans threatens banks' ability to grow. JPMorgan's net loans were $713 billion at the end of 2008, and $702 billion in the most recent quarter. Total assets grew over the period because the bank ratcheted up its exposure to investment securities (things like Treasuries, municipal bonds, and mortgage-backed securities).

The biggest threat here is that banks will be tempted to loosen loan standards to widen the pool of potential customers. We already saw a version of this at JPMorgan earlier in the year: The $6 billion London Whale trading loss came from a division that invests JPMorgan's deposits in excess of loans. The division, called the Chief Investment Office, grew by nearly $100 billion in the last three years as loan demand waned and excess deposits piled up. What investors learned the hard way is that the division effectively became an internal hedge fund with more money than it knew what to (safely) do with, and its response was to take risks well beyond expectation. Mo' money, mo' problems.

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$12.5 Billion on litigation? Is that a typo? That's like spending a million dollars each on 12,500 different lawsuits! I can't even comprehend that, much less what they're doing with their derivitives.